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If your company suffers from growing pains or anticipates a hard stretch due to the current economic climate, you may want to consider a spin-off. Spinning off a business or unit can provide a variety of benefits, such as yielding much-needed cash, removing poorer-performing entities from your balance sheet and freeing up management to concentrate on your core business or pursue more profitable initiatives. To effectively grow your company, in fact, you may need to first scale back.

Several Forms

Spin-offs can take many forms and are accomplished in various degrees. A unit may be fully divested of its parent and become an independent, publicly owned entity. Or it may merely become a subsidiary of the original company, gaining owners but still being run by the same management.

Whatever the spin-off form a company adopts, a wholly owned segment of a larger company becomes a fully or partially independent business. Most often, the divested company’s shares are offered in the public marketplace.

Staging the Transaction

Spin-offs involve several stages, the first – and one of the most critical – being the “pre-spin” period. This is when a company prepares a division to be spun off and announces its intentions to the public. During this period, the company will work with the IRS and SEC to ensure the proposed deal meets all tax and regulatory requirements. The company also must gain its board of directors’ final approval.

From here, spin-offs generally are executed in one of two ways:

Pure spin-offs. This is when the parent company distributes 100% of its ownership of a subsidiary operation as a dividend to current shareholders. After the spin-off is complete, there are two separate public companies. Shareholders have the option of selling their holdings in the new entity, if desired.

Partial spin-offs. Here, the parent company sells an interest of less than 20% in the subsidiary in an SEC-registered initial public offering. This method often appeals to companies that need to raise capital but want to maintain ownership of their subsidiary or shine a spotlight on an undervalued division.

Which type of spin-off a company should pursue primarily depends on its long-term goals. A partial spin-off, for instance, may be a better choice for a division that’s not yet ready to stand on its own but that a parent company nevertheless believes the market has undervalued. Spinning off part of the division could enhance its value for an eventual sale or pure spin-off.

Why Do It?

Spin-offs have long been a popular and successful way for companies to improve their bottom lines and streamline strategic plans. As of this writing, General Electric, for example, is in the process of spinning off its 101-year-old, low-growth appliance business, planning either to sell it outright or accept outside investors in a strategic partnership.

Companies spin off divisions for many reasons. A company may need to raise cash for capital-intensive projects. Similarly, a unit’s elimination could improve the parent company’s credit rating and make it a more attractive loan candidate. Some companies even enjoy tax benefits from a spin-off.

Government regulators may require a public company to remove a division if it’s considering a merger with a competitor. For example, the Federal Trade Commission might ask merging companies to divest similar businesses that could, if joined, enjoy too large a market share.

Sometimes spin-offs are accomplished for strategic reasons. A company might spin off a healthy entity with strong growth prospects to gain greater investor attention. Say, for example, that a company has a promising software division that’s undervalued because its parent company isn’t well known in the software sector. If that division is put up for sale and no longer buried in a larger company’s basement, it could receive the market attention it deserves.

Finally, a unit could be a poor performer that has become a drag on the parent company’s earnings. Selling troubled units can be challenging, however. To compensate for additional buyer’s risk, you may need to retain an equity stake in the division or provide financing for the seller.

Benefit of Separation

Whether your company is undercapitalized and looking for cash with which to pursue new markets or make business acquisitions, or you simply believe that a current division could be more competitive as a separate company, consider a spin-off. Separations can be painful, and they require some time and expense. But the benefits can more than make up for the trouble. ______________________________________________________

Ensure Your Spin-Off Isn’t Taxing

One advantage of spinning off a subsidiary is the potential for major tax savings. Although, selling a subsidiary outright typically means that your company will pay substantial capital gains taxes, tax professionals can help you structure the transaction to minimize the burden.

The key is to comply with Internal Revenue Code Section 355, which requires a spin-off company to have existed as a subsidiary for at least five years. It also demands that:

The spin-off be undertaken for “a real and substantial non-federal tax purpose” and not just to dodge the IRS;

Before the spin-off is conducted, the parent company own at least 80% of the total combined voting power and 80% of each class of nonvoting stock of the subsidiary;

Both parent and subsidiary be involved in what the IRS terms an “active” business immediately after the spin-off, and

At least one shareholder of the parent company retains a minimum 50% equity interest in the spin-off.

If you spin-off doesn’t conform to Sec. 355, your company could be held liable for the full tax obligation on the divestiture. Meanwhile, your shareholders could be taxed as if they had received a dividend. _______________________________________________________________